The Issue – March 2016

Publication Date: March 29, 2016

MAKING A “CAPTIVE” WORK FOR YOU

Turn Risk Management into a Profit Center

By Joe Markunas

I would like to discuss a risk management tool which, until recent changes in tax legislation, has only been available to very large companies. The tool to which I refer is known as a Captive Insurance Company (CIC or Captive). Quite simply, a CIC is a property and casualty insurance company that provides coverage primarily for an operating parent company.

The concept of a captive insurance company (aka self-insurance) is not new. In fact, many recognizable corporate giants employ self-insurance as a key feature of their risk management strategy. Whether used by a very large or mid-sized company, a well-structured CIC that is operated as a legitimate insurance entity and which complies with applicable insurance and IRS regulations can provide the owner of the CIC with significant risk management, income tax, investment and other benefits.

The Process

A Captive is formed as a separate insurance company that can be owned by the operating company, a parent company or another person or entity to insure the operating entity against any number of risks for any number or reasons. For example, the operating company may require coverage for one or more enterprise risks for which there is no available coverage or the coverage, if available, is too expensive. Examples of such risks include loss of a business or professional license, adverse financial impact of regulatory or legislative changes, loss of a key vendor or major client, loss of franchise license or lease and environmental losses to name just a few

In other cases, the operating company may be in search of a more comprehensive risk management program in which case the Captive can provide additional coverage to supplement already existing coverage.

In designing a CIC the services of a risk management consultant and/or actuary are typically retained to identify the insurance risks to be covered as well as the premiums to be charged by the CIC to cover those risks. These services can either be provided by standalone risk professionals or may be obtained from risk management groups that will provide these services as part of their fees to design, implement and maintain the Captive.

The Benefits

Once risks are identified and premiums calculated to cover those risks, the premiums are paid by the operating company to the Captive for which the operating company should receive a tax deduction as an ordinary and necessary business expense under Internal Revenue Code (IRC) Section 162. On the other hand, IRC Section 831(b) provides that Captive is taxed only on its investment income, and not the premiums received from the operating company, so long as the premiums to the captive do not exceed $2.2 million per year (indexed for inflation annually after 2016).

Aside for providing that a CIC generally does not report premiums up to $2.2 million as taxable income, IRC Section 831(b) also states that Captives may be taxed only on their investment income. Further, the captive may retain surplus from underwriting profits (see below) free of income tax. Another potentially significant tax benefit is that Captives are taxed on investment income at corporate tax rates and dividends paid out of the Captive, if any, will generally be taxed at favorable long-term capital gains rates as a qualifying dividend. Your tax and investment advisors should be consulted to take maximum advantage of these favorable tax and investment strategies.

Surplus underwriting profits, which may be retained free from income tax can be generated in a number of ways. For example, the CIC can be profitable due to its ability to control or eliminate overhead that is typically incurred and built into premiums by commercial insurers. After the payment of expenses and claims the Captive may have net underwriting profits which may be retained by the Captive tax free.

In fact, profits and surpluses could be experienced and retained over a period of years and may accumulate to a substantial amount. Current tax laws provide that these retained surpluses and profits may be distributed to the captive’s owner under favorable income tax rates as either dividends or as long-term capital gains.

A Few Words of Caution

As with any tax favored business strategy or structure, the tax and regulatory rules governing Captives are to be followed rigorously if the Captive structure is going to be recognized by taxing authorities and state insurance regulators. Again, the caveat that tax, legal and insurance advisors need to be a part of the planning and implementation process is to be repeated here. But the benefits of a well-designed and executed Captive may be well worth the effort and cost in terms of tax and insurance cost savings and having coverage for risks previously uncovered.

First and foremost, a Captive must have a legitimate business purpose which is to provide appropriate insurance coverage to the insured(s) that are paying the premiums. Therefore, the Captive must have “economic substance” as used in the Internal Revenue Code. In other words, as a CIC it must look AND act as an insurance company in both structure and management.

That means that the risks covered must be real and the premiums charged to cover those risks appropriate. Both must fall within the criteria of commonly accepted insurance provisions regarding risk shifting from insured to insurer. There are CIC design and administration firms who can evaluate risks to be covered by the CIC and determine the appropriate premium.

In Technical Advice Memorandum 200816029 (April 18, 2008), the Internal Revenue Service has stated that cases involving “captive insurance” arrangements have distilled the concept on “insurance” for federal income tax purposes to three elements, applied consistently with principles of federal taxation:

Involvement of an insurance risk

Shifting and distribution of that risk

Insurance in its commonly accepted sense

Summary

It is for these reasons that risks that can reasonably be covered by existing property and casualty (P&C) insurers at a reasonable cost will typically continue to be insured under standard P&C coverages. Otherwise, why set up a Captive to cover these risks which are already covered by your P&C insurer at competitive rates?

However, there are a number of risk management advantages that can be gained by a Captive as follows:

Greater Control over Claims

Coverages not otherwise available

Supplemental coverages

Underwriting Flexibility

Access Reinsurance Market

Incentive for Loss Control

Reduced Insurance Overhead Costs

Capture Underwriting Profit

Pricing Stability

Improved Claims Review and Processing

Purchase Based on Need

Tax Benefits

Investment Income

Additional Profit Center

A company of any size and insurance need can establish a Captive. However, legal, accounting and other transaction costs will typically dictate which companies will find the cost benefit features of a Captive attractive.

Fortunately, there is a long history of case law to guide the captive implementation and regulatory team throughout the process, enabling the experts to design a compliant captive insurance company. Better yet, through the application of “safe harbor” Revenue Rulings, the business owner has a clear path for captive design with predictable tax results.

It is advisable to work with your team of legal, tax and insurance advisors when evaluating a Captive. Additionally, include a risk management/captive administration specialist that has obtained independent tax opinions on its CIC design. In so doing, you should end up with an arrangement that constitute insurance for federal income tax purposes and that amounts paid as premiums are deductible as insurance premiums under Section 162 of the Code.

As mentioned previously, the main advantage of a CIC is to obtain insurance protection for risks not otherwise covered under typical property and casualty policies. However, the downstream benefits of profit accumulations in the CIC and tax advantaged ways to access these accumulations are significant as well. In fact, a well-designed and manage CIC can be part of long term expansion/capex, retirement and even succession planning.

Self-insuring under a CIC is no longer restricted to large or multi-national public companies. Consequently, it makes sense for businesses of all sizes to consider the use of a CIC in any comprehensive risk management plan.

I welcome your comments and thoughts, please contact me to continue the dialogue.

Joe Markunas is a Partner at CFOs2GO where he leads the Healthcare & Life Science Practice and is a contributing partner on succession planning, small business, family office, non-profit, international and cleantech practices. Joe’s background includes accounting, tax and consulting engagements with both large and small firms.